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August 26, 2013

Arnott’s Value Firm Grabs Momentum ‘Hot Potato’ in Paper

Research Affiliates paper cites risks of momentum investing but says it could improve returns as a short-term add-on

Research Affiliates is best known for its fundamental indexing strategies that seek to capture inherent value that capitalization-based indexes based on market price overlook.

It is therefore something of a surprise to see in the August newsletter of Research Affiliates, the Newport Beach-based firm founded by Rob Arnott, a not entirely negative evaluation of momentum-based investing, which is, after all, a strategy that is opposite to value investing (on which fundamental indexing is based).

The article, “Hot Potato: Momentum as an Investment Strategy,” by Research Affiliates Vice President Ryan Larson, describes momentum as a “lively game of hot potato—buying rapidly appreciating stocks, holding them for a relatively short period, and selling them before their price trends reverse direction.”

Larson reviews evidence for momentum and cites studies showing it can have superlative results in favorable conditions. For example, he cites the first comprehensive study of the subject in 1993, which found momentum to be the best-performing strategy from 1965 to 1989. In that period, that entailed buying stocks that outperformed the previous 12 months while shorting losers and holding those positions for the subsequent three months.

While empirical results were favorable, Larson’s review of the evidence finds no theoretical support that can scientifically account for why that strategy would outperform.

Larson next looks at momentum through the prism of Fama-French-Carhart equity risk factors—beta, value, size and momentum—and there, too, finds that momentum, impressively, registers the highest return and Sharpe ratio from 1970 to the present.

Despite its high returns, it is in the risk area that Larson argues against momentum as a standalone strategy. Momentum, like the other equity risk factors, has its seasons of success and failure. In fact, momentum has earned a negative risk premium for the past 13 years.

“Although momentum and value factors have similar Sharpe ratios over time, momentum has 50% higher volatility," Larson writes, "whereas value is more stable and, perhaps, more intuitively appealing.”

Larson cites research by Eugene Fama and Kenneth French showing that momentum works best in illiquid, smaller-cap stocks, and significantly, that the turnover required to capture momentum generates high trading costs that can “offset the alpha potential at a fairly low level of assets invested.”

Ultimately, the Research Affiliates staffer stands by the value strategy — which involves “systematic rebalancing to constituent weights that are not related to prices" — for which his firm is best known, but endorses adding momentum as a short-term portfolio-enhancing tactic.

“I submit that complementing a long-term fundamentals-weighted strategy with a judicious commitment to a short-term momentum strategy might, in aggregate, produce attractive risk-adjusted returns," Larson cloncludes. "Indeed, Morningstar found a blended portfolio of value and momentum outperformed a blended portfolio of value and growth by nearly 1% annually.”